What Defines a General Partnership?
A general partnership is a basic form of business entity. It may be described as an agreement between two or more parties who decide to share an interest in a business endeavor, of which they will share the profits and losses. To create a general partnership, there is no need to file with the government. In fact, a partnership can result naturally from the activities or actions of the involved individuals. A general partnership is similar in structure to a sole proprietorship, but it requires more than one person in charge.
The agreement between the partners does not have to be expressed or written. Rather, it may be implied from the partners’ actions. It is important to remember that a general partnership is a default form of entity. This means that the partners are not required to have the intent of creating a partnership. They also do not have to possess the understanding that a partnership has officially been formed. According to the doctrine of partnership by estoppel, a court of law can decide that a relationship is a partnership when the necessary elements exist.
The involved partners can produce a written agreement, otherwise known as a partnership agreement, which officially established their general partnership. A partnership agreement is the document that governs any kind of partnership. While partnership agreements may not be mandatory, it is still advised that partnerships have them. By recording the relationship between individuals involved together in business, a relationship can be formally recognized as either an employer-employee relationship or a general partnership. Without a formal agreement in place, states have rules that cover most scenarios, but do not always align with the partners’ wishes. If a partnership wishes to hire an individual and reward them with a share of the profits, the partnership will need to document the employment relationship. This could mean special structuring of any shared profit as a bonus granted to the employee instead of an ownership percentage.
There are no formal maintenance requirements for a general partnership, though there are default rules which provide for the rights of the partners in the relationship. These rights may include the ability to vote for specific partnership decisions and the right to partnership profits. The rules make up a government requirement that could be considered maintenance of a business entity.
What Are At-Will Partners?
As discussed above, a general partnership might naturally occur when individuals decide to pursue a mutual interest to make a profit. That is to say, the individuals did not intent to become partners, but their business was nevertheless considered to be a general partnership at-will.
What does at-will mean? It establishes that there was no official agreement in place indicating the time period the partners were to work together. This means that any partner has the freedom to leave the partnership whenever they please. When a court looks at a relationship to determine if it is a partnership, it will look at the sum of the circumstances. This means that the court will look at any evidence that shows the partners’ activities meet the state law requirements of a partnership. The circumstances may directly point to a different kind of relationship, such as an employer-employee relationship. If this is the case, then the individuals will not be defined as partners, avoiding the default obligations and rules that come with this assignment.
What Is the Ownership of an At-Will Partnership?
As a default, the partners of an at-will partnership equally share in the ownership of the company. This is regardless of whether the partners contribute different amounts to the partnership through labor or assets.
Who Has Authority in an At-Will Partnership?
By default, each person in a partnership has the authority to participate in the management of the company. Similarly, each partner has the power to act on behalf and bind the company in contracts or agreements.
Who Has the Decision-Making Power in an At-Will Partnership?
By default, partners are allowed to participate in company management decisions. In general, a majority of partners will make mundane operational decisions. Big decisions, however, will require agreement from all members of a partnership.
What Is the Personal Liability of Owners in an At-Will Partnership?
As with any general partnership, partners in an at-will partnership have unlimited personal liability for the actions of their other partners. Similarly, the partners are personally liable for the partnership’s obligations or debts. This might include a scenario where the other partners bind the company when they lack the power to do so.
What Are the Fiduciary Duties in an At-Will Partnership?
Partners have a fiduciary duty to act in their company’s best interest. This duty is often misunderstood as a duty to act in the partners’ best interest. The point of fiduciary duty is for partners to avoid acting for their personal benefit or to the detriment of their other partners.
What Is a General Partnership Agreement and What Should It Say?
A partnership agreement is the document that determines how any kind of partnership is run. While partnership agreements are not mandatory, it is a good idea for a partnership to have an agreement that details the terms of the relationship. Without a formal agreement in place, state laws come into play by default. While these state rules are fairly comprehensive in nature, they do not always align with the interests of the involved parties. Most states use the Uniform Partnership Act, which provides the rules for governing partnerships. However, some states have their own common law rules which might affect the duties between partners.
Like any other business entity document, a partnership agreement should be created to address specific concerns of the partners and their business. The following are some of the common points to address in a partnership agreement:
It is important to check that the desired name for the company is available. One may determine this by checking with the Secretary of State’s office. Also, if a partnership is going to operate under a name that is different than that of the partners, then it should file a DBA, or doing-business-as filing. This should be submitted to the Secretary of State’s office or the local authorities.
The partners should determine how the ownership interest is divided between them. They should figure out what each individual will contribute to the company and what share of partnership interest they will get in return.
Entitlements of Partners
In general, each partner is entitled to an equal part of the business’ profits and losses. However, if the parties want a different division of ownership or entitlements, then a partnership agreement can establish this unique allocation. One unique fact about partnerships is that, mostly, partnerships can distribute profits and losses in a different percentage than the ownership structure. Also, the agreement can determine the amount and timing of any distribution of assets and profits. This provision is an important one, because partners may have different ideas about how and when they can draw from partnership profits.
Authority of Partners
This provision determines who has decision-making authority in the partnership. It may be established who has the power to make specific decisions, as well as which decisions require a consensus. Also, which parties have the power to bind the business in contract? The default rules grant each partner the authority to act on behalf of the business and bind the company in contract.
It may be good practice to give certain partners main responsibilities. It can often happen that partners disagree over who should be in charge of various activities within the company. These terms do not have to be concrete, but they can provide a guideline for partners regarding their duties.
Addition of New Partners
This provision establishes the process for bringing on new partners. It should be determined if consent is required from all partners to add someone new. Will unanimous consent be required, or is a majority enough? Also, these terms specify how assets, profits, and losses will be allocated to a new partner.
Continuity of the Partnership
This provision determines what will happen if a partner breaks from the business or is kicked out. These terms establish the procedure for exiting the company, as well as how the departing individual’s interest will be handled. Also addressed is the issue of the partnership’s future. If a partner leaves, does the partnership continue, or does it close? How does the result change if the exit is voluntary or forced? There are also provisions for if a partner passes away.
This crucial part of the agreement addresses how partnership conflicts will be resolved. It may be decided that there will be mediation or a third-party arbitrator, for example.
What Is a Buy-Sell Agreement?
A buy-sell agreement details the process for a partner who is exiting the general partnership. This process can be included in the partnership agreement or it can be its own separate form. In general, this document outlines the process for dissolving or continuing the company if a partner leaves. It can offer procedures to follow after either a voluntary or forced exit. A buy-sell agreement will address the following issues:
- Can a partner be forced out?
- When does the general partnership have to buy out or liquidate the partner’s interest?
- How is the partner’s interest divided and liquidated?
- What method will be used to value the business and the leaving partner’s interest?
- Is an exiting partner able to transfer their interest to a third party or is he or she required to sell it back to the partnership?
- Does the result change if the partner passes away, retires, or loses their mental capacity?
What Other Steps Are Necessary to Form a General Partnership?
While participating in business activities makes a partnership by default, there are other steps involved in cementing the partnership as well. Other considerations include the following:
- Filing a business name with local and/or state authorities (DBA filing)
- Creating a partnership agreement
- Getting a business license
- Registering for a federal EIN and state identification number
- Getting any federal, state, or local licenses and permits
It should be noted that each state has its own requirements for companies that conduct business in their jurisdiction. If a partnership does not follow these rules, there can be civil and criminal penalties.
What Is the Continuity of the General Partnership?
The lifespan of a partnership is determined by the partners’ intention. If it is an at-will partnership, then there is no set timeframe provided. The partnership will continue until the partners decide to dissolve the business. The partners may choose to create a time period for the general partnership. After the period expires, the partnership would dissolve. This kind of partnership is known as a term partnership. This means that the partners have the duty to remain partners for that set term. However, if the parties do not create a set time period for the partnership’s existence, then the relationship is considered an at-will partnership. This means that the partners may leave the partnership whenever they please.
It should be noted that if there is a conflict between partners over income or assets when the company is dissolved, each partner is entitled to an accounting of the partnership’s assets. This is an equity action that figures out each partner’s rights to assets. This is an important right because partners usually cannot sue one another over dollar damages related to dissolution.
How Is a Partnership Terminated?
When there is no written partnership agreement in place, a partnership will end when a partner expresses his desire to leave the company. When there is a written agreement, the partnership will end when one of the situations discussed in the agreement happens, or when a majority of the partners agree to end the partnership after a partner exits.
When it comes to terminating a partnership, written agreements can be very useful in detailing a process to follow. For instance, the partnership can provide for the remaining partners to continue the business if they so wish. Regardless of whether there is a written agreement, it is still pretty easy to leave a partnership. However, an exiting partner will still be responsible for his or her obligations to the partnership. Thus, ending a partnership is more of a process than a single action. This is because the business needs to be wrapped up, including paying outstanding debts and fulfilling contracts.
One advantage of partnerships is the ease with which profits turns into personal income, as well as the ease of formation. However, there is the disadvantage of personal liability for the company’s obligations. A business owner has the burden of assessing these factors to decide whether a partnership is the right move for them.
A partner has the right to leave the partnership at any time. This right, as well as other partners’ actions, may lead to a dissolution. Without an agreement that states otherwise, the following scenarios may lead to a partnership dissolution:
- A change in partners
- Expulsion of partner that breaks the partnership agreement
- It is no longer possible to continue business
- The partnership activity becomes illegal
- Death or bankruptcy of a partner
It should be noted that if the partnership is wrongfully dissolved, then the remaining partner may continue the business. However, he or she must come to a settlement with the exiting partner.
A partnership agreement may determine the continuity of a partnership. If there is not a partnership agreement, then the partnership does not have continuity. This means that by default a general partnership dissolves when a member leaves. Thus, a partnership interest cannot be transferred to one’s heirs. That said, most states allow remaining partners to amend the general partnership to continue the business after paying the exiting partner their interest.
It should be noted that the transfer of a partner’s interest may lead to other partners’ right to leave. An exception to the default dissolution provision is when a partner passes away or suffers mental incapacity. In this situation, a partnership does not automatically dissolve.
As previously discusses, partners can alter the default rules of a partnership by creating a partnership agreement. This agreement can also provide the procedures for closing the business or allowing the remaining partners to keep the business operating. The agreement can also divide the responsibilities for partnership debts or distribute the profits at the time of dissolution.
These kinds of agreements are known as buy-sell agreements.
Who Owns a General Partnership?
General partners are the owners of a general partnership. The partners can agree on what percentage of ownership each member has. If there is no partnership agreement, then default rules control the way a partnership operates. These rules establish that partners are entitled to equal ownership rights. This means that the partners equally share the business’ profits and losses – that is, unless they agreed to a specific allocation of profits and losses within an agreement.
By default, ownership interests cannot be transferred to third parties without the existing partners agreeing first. If a partner attempts to transfer his or her ownership interest with approval from the other partners, then this qualifies as grounds for dissolution of the partnership.
Who Has Control of a General Partnership?
The members of a partnership have complete control over the partnership. The partners therefore have the authority to make decisions regarding the company’s operation and strategy. They also have the authority to act on behalf of the partnership as an agent. The partners can create a partnership agreement that alters or limits a partner’s control or voice in the partnership, if they so wish. However, even by limiting this authority, the partner may still bind the partnership by conducting transactions or establishing relationships with third parties, such as sales agreements or loans. As a protection, the partnership can limit the authority of this partner to bind the partnership by notifying any third party that the specific partner’s authority is limited.
It should be noted that some decisions require both partners to give their consent.
What Are the Partner’s Duties to the General Partnership?
By default, the members of a partnership have obligations to the partnership. As an agent of the partnership, these duties tend to be fiduciary. This means that a partner has the duty of loyalty and card toward the partnership. The duty of care means that the partner must show reasonable care in conducting partnership business. The duty of loyalty means that the partner must act in the best interest of the partnership. This means that the partner cannot put their personal interests ahead of those of the general partnership.
That said, partners can alter the default rules that control a partnership by creating a partnership agreement. For instance, the partners may establish a time period for the partnership, and after the time elapses, the partnership automatically dissolves. The agreement could also establish the procedures for closing the business or permitting the remaining partners to continue operating it. It can also assign responsibility for debts or proceeds at the time of dissolution.
What Is the Personal Liability of Partners in the Partnership?
Like a sole proprietorship, a general partnership does not offer its owners any kind of liability protection. This means that each partner is held personally liable for any of the business’ obligations, debts, or tortious conduct. If the business were to top operating or goes bankrupt, then the partners are liable for the business’ obligations and debts. Also, each partner can be held entirely liable for the entirety of the business’ debt. This is called joint and several liability.
According to the law of agency, the partnership is liable for obligations that have been created by its agents or their tortious conduct. This means each partner may possible be personally responsible for the actions of partners and employees of the partnership.
This can be true even if a partner or employee goes beyond their authority as established in a partnership or employment agreement. Because of this, a general partnership is not the most risk-averse entity a business owner can choose.
How Are Partners Compensated?
Members of a partnership receive their compensation by drawing a share of partnership funds (mainly profits). This is called the partner’s distributive share. In general, this draw represents each partner’s percentage of ownership. That said, the partners may choose to have an agreement that distributes the profits and losses differently than in the ownership structure. In short, this means that a partner might receive a greater percentage of profits or losses than is represented by the ownership percentage. However, this kind of alteration must be justified by the partnership’s economic reality. Perhaps one partner is spending more time working for the partnership.
Partners are not allowed to receive a salary that is based on their ownership percentage or for any of their services to the partnership. Only employees may receive a salary as a form of compensation. Because profits and losses can generally be distributed in any manner, partnerships are a preferred tax entity. When a partner’s entitlement to profits or losses does not have to match their ownership interest, this is known as a special allocation.
What Is a Special Allocation and How Does It Work?
Instead of receiving a salary for their services to a general partnership, partners receive a distribution of partnership proceeds. Because, by default, partners have equal ownership in the partnership, profits and losses are distributed equally. However, if there is a partnership agreement that says differently, then the allocation of profits and losses may be altered.
It should be noted that special allocations may be reviewed by the Internal Revenue Service (IRS). The company must provide a valid reason for using the special allocation, rather than merely using it to lower the tax liability for a single person. The IRS will use a substantial economic effect test to see if there is a legitimate economic reason for the company or its partners to make special profit and loss allocation.
How Is a Partnership Taxed?
As entities, general partnerships cannot be taxed. Instead, they qualify as pass-through tax entities. This means the partnership will subtract expenses and deductions from the company’s revenue in order to determine profits and losses. Similar to a sole proprietorship, partners record their share of the partnership’s profits and losses on their personal income tax returns. However, the partnership itself does not have to submit a tax return. This kind of return is called an informational return. It is submitted via IRS Form 1065. The return details the revenues and expenses that occur due to operations. It also includes the percentage of the profit or losses each party is entitled to. The partnership is required to give each partner a Form K-1 that details the partner’s share of profits and losses. These amounts will be included on the partner’s individual tax return.
It should be noted that a partner must pay taxes on their percentage of partnership profits, regardless of whether they withdraw the profits from the partnership or leave the profits in the company.
What Is a Partner’s Tax Basis?
When it comes to general partnership taxation, the rules are unique when compared to other entity types. Each partner should track their basis in individual assets within the company. If the assets are at some point sold by the partnership for a gain or loss, then the individual who is offering the assets to the company may be granted income that is based upon his or her basis in the assets. Tax basis is generally considered to be the value of assets that a partner contributes to the partnership. Though accurate, this is still too simple an explanation.
This is because a partner’s basis also involves other elements, including any relief of liability on debt that the partnership assumes, or the business debt which the partner is personally liable for. It is important to recall that the partner does not need to personally guarantee the partnership debt, because partners are personally liable for any company debts. A partner’s basis will increase by the product of their ownership percentage multiplied by the amount of debt the partnership assumes.
What Happens if the Partner Wants to Make a Distribution When It Is Not Profitable?
It may still be possible to distribute funds to partners even if the partnership is not profitable. If the partnership grants a specific amount of funds to a partner that goes beyond the business’ annual profits, then the partner’s basis is reduced by that amount. One should remember that the profits of a partnership qualify as personal income for the partners. If the company is making a profit, then the partner’s distribution may be regarded as a return of invested capital. If a distribution takes a partner’s basis to below $0, this results in taxable income for the partner.
What If Partners Choose to Leave Profits in the Business?
If members of a partnership choose not to distribute the partnership profits, then the percentage of business profits is still taxable to each partner. In the tax world, this is known as phantom income. The partners will record their share of profits on their personal tax returns even if it is not distributed. The general partnership will have increased operating funds. Also, the partners’ basis is raised.
What Happens If the Partnership Endures Losses?
As is the case with profits, losses pass through to partners and will be documented on their personal income tax returns. Because each partner is actively involved in the partnership, they can use the losses to balance against active income coming from other sources. However, the losses cannot be used to balance against passive income.
How Is a Partnership Funded?
Members of a partnership fund the company by contributing assets. The value of these offered assets becomes an ownership interest in the company. If the partners offer assets of equal value and the partnership is divided in equal parts, then there is no tax dilemma. However, if one partner contributes more assets but the ownership percentages are still equal, then the partner contributing assets of a lower value is regarded as having gotten income from the partnership. The income granted to this partner is equal to half of the difference between the value of the offered asset. This qualifies as a type of phantom income.
A partner may have a basis, or amount of invested money, in the asset that is higher or lower than the value offered to the partnership. In general, the partner does not accept any income or losses when offering this asset to the partnership. However, the partnership takes a basis in the asset that is equal to that of the partner making the contribution.